Commentary: 2012 Third Quarter Commentary
by Franco Seguso, September 2012

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Recession fuels monetary reflation

The third quarter perfectly epitomizes a growing disconnect between financial markets and underlying economies, between policy-makers and society at large or the famed divide between Wall Street and Main Street; could it be that Monsieur Market and Madame Economy are divorcing, the former bubbled-up by central bank perfusions, the latter depressed by revenue and productivity leakages?

Here we are, in the midst of a synchronized global slowdown, possibly on the brink of a global recession; economic fundamentals are dreadful and continue to surprise on the downside while financial markets have parted way from economic reality and surprise continuously on the upside in the face of declining earning (multiple expansion), fuelled by the incessant flow of monetary stimuli.

Not surprisingly, in the past quarter all the major central banks have announced new rounds of monetization, some with open-ended features. These actions are testament to policy-makers inability so far to overcome the deflationary forces unleashed by the bursting of the credit bubble in 2008.

Monetary policy has become the only game in town, but in the process has also become hostage to three overwhelming forces: market-driven expectations, political expediency and balance sheet limitations.

Stockholm syndrome

Financial markets have cornered central banks by demanding a never ending injection of easy money or risking Armageddon (debt deflation); as markets are moved by the flow rather than by the stock of money, each injection begets the next one once the sugar-high impact fades out. Lather, rinse, repeat.

What is more, central bankers have willingly become prisoners of politics in a classic case of Stockholm syndrome: their unrelenting monetary voluntarism has turned into a surrogate for political inaction from Tokyo to Washington to Europe at large. Why face voters’ revolt when you can outsource the financing of your fiscal problems to your monetary authorities: après moi, le deluge!

Eventually there is the issue of bloated central bank balance sheets and exit strategies: any hint of a policy inversion toward the exit would become self defeating. Markets will immediately front run the monetary authorities, denying them the capacity to meaningfully reduce their balance sheets without debilitating impacts on interest rates along the entire yield curve. And today’s over-leveraged economies are in no position to withstand the burden of higher real interest rates. The larger the balance sheet, the more remote the eventuality of any exit: welcome to the age of too big to exit.

From my lenses central banks have past a point of no return: open ended monetization has replaced exit strategies. They are constrained to inflate their way out of this debt-pyramid corner rather than risk deleveraging their balance sheet in the context of excessive and unserviceable debt globally.

Policy-makers are committing to subsidize much of this debt by monetary inflation as debt defaults or even pay-downs (higher savings) would entail intolerable risks of a deflationary outcome. There is simply too much debt and unfunded entitlements at all levels of society relative to the capacity to service these obligations from current incomes.

Our task is to identify where this open-ended monetization will flow as money has to find a home; and to anticipate some of the unintended consequences of this monetary experimentation as we move further and further away from conventional policy.

Inflation is not always discernible, neither are unintented consequence

Since the middle 80s inflation has manifested itself mainly through the asset prices channel rather than through the CPI channel. The main reasons for such a benign (albeit manipulated) CPI background have been identified in the technology-led productivity revolution, globalization and deregulation, all of which have kept labor costs, the main driver of CPI inflation, under pressure.

Real household disposable incomes have been declining since over ten years in the face of unrelenting inflationary pressures in food, energy, education and healthcare (non-discretionary spending) partly compensated by deflationary trends in labor costs (adjusted for productivity), electronics, durables and apparel goods (discretionary spending). Within the CPI we thus have sustained inflationary pressures in what we necessitate partly balanced by disinflation from what we already have or may want to consume.

Unable to grow revenues from labor sources, households have thus increased their consumption ability by leveraging their balance sheet through diminishing savings and increasing amounts of debt and entitlements. The old fashioned way to save from labor was replaced by asset inflation as the main source of savings. Moreover, in a circular vicious logic, inflated assets were then collateralized to fund consumption with more debt, itself to be repaid from further asset inflation. Until the bubble burst and losses are apportioned, usually socialized.

In the last three decades the world has lurched from one asset bubble to the next with increasing frequency and virulence (Latin America debt, 1987 crash, Japan real estate and equity bubbles, South-East Asia crisis, Mexican crisis, Russian crisis, LTCM failure). Since the beginning of the millennium we followed up with the DOT-COM bubble, then the credit-housing bubble and now the credit-sovereign bubble.

Each of these bubbles was by itself a hyper-inflationary episode, usually bigger than its predecessor and each was fuelled by a combination of easy money and fractional banking leverage. Each episode resulted in the underlying asset expected return (yield, rent, dividend, P/E, etc…) falling below CPI inflation. Each was in insight a malinvestment and resulted in the arbitrary suspension of market discipline mechanisms (through price controls, capital and exchange rate controls, interest rate manipulations, financial repression, etc.). And each bursting has served as a rationale for central banks to implement incremental monetary easing.

Today unconventional monetary policy is driving the yield curve of some major assets (sovereign and AAA bonds, rents from Hong Kong to London, deposit rates, money market funds) below inflation in a blunt warning that another very big credit-induced bubble is in the making.

Central banker’s paradigm shift: from printing debt to printing money

Central bankers are clearly scared by the ravages that the bursting of the credit bubble they created and abetted in the first place could wreck on the world economy. After decades of a worldwide debt super cycle came to a sudden standstill in 2007, our monetary wizards have engineered ZIRP (zero interest rate policy) to replace demand driven by debt with demand driven by asset prices (wealth effect) as well as to subsidize the cost of carrying increasing debt loads.

ZIRP five year old policy seems to be stalling on the aggregate demand side as wealth effects have much lower traction on demand than debt. This is inducing our serial monetarists-cum-Keynesians policymakers’ towards the next coherent step to maintain-demand-at-any-cost: outright printing of money. After subsidizing debtors through negative interest rates for five year, the process is now moving towards subsidizing principal reduction by inflating debts away.

Our central bankers, cornered by markets, politicians and the sheer size of their own balance sheet, are now engineering a debt jubilee through the electronic printing presses in order to negate a prospective deflationary toxic cocktail of debt-deflation and default.

This is also the political path of least resistance, is remote from the boundaries of accountability and is fiscally regressive but by stealth. Monetization is just fiscal policy by a different name; it is the equivalent of a large transfer tax from savers to debtors.

By flattening the yield curve to financial repression levels, policy makers are also inflating a bubble of epic proportions as an ever increasing amount of debts and entitlements is carried along by a negative real yield. Like any other inverse relationship, its inherent instability increase commensurately with its size: the bigger the pyramid of debt and entitlements sustained, the larger any fractional increase in the cost of carry is bound to be significant.

ZIRP and monetization redistribution impacts

ZIRP in concert with monetization distorts asset prices normal market mechanism (price discovery) by flattening risk premiums and volatilities across asset classes; bonds and equities higher prices are predicated on manipulated lower yields and higher multiple rather than on lower inflation and higher earnings respectively.
 
If debt is a mechanism to consume today something that will have to be repaid from future cash flows, the flattening of risk premiums is a mechanism to extract higher values today that will be ‘repaid’ from lower yields/returns in the future. Both are transfer mechanisms to borrow present value from future incomes and could back-fire if the manipulation cease.

ZIRP and monetization are thus blunt tools used to inflate asset prices by artificially keeping the cost of money below the inflation rate. It forces the yield-dependent crowd (retirees, savers and conservative investors) to compensate ever diminishing low-risk returns by increasing exposure to risk and duration as the powerful forces of compounding are suppressed.

Savers and those dependent on fixed income are the primary losers of the monetization process as wealth is confiscated to the benefit of debtors through financial repression first and inflation later. Conversely, primary dealers and the usual insiders with access to central bankers are able to front run the printing presses and pocket what is in essence a monetary subsidy.

ZIRP is also wreaking serious damage onto the financial system, in particular on spread-dependent industries (money-market funds, banks, hedge funds) and compounding dependent businesses (pension, insurances, wealth managers).

Winners include owners of capital (richest decile) as the cost of money has been zeroed while conversely labor (all the other deciles) is the major loser as its relative value to capital continues to decline. Monetization also acts as a regressive stealth tax as it impacts disproportionally food and energy prices, squeezing discretionary incomes of poorer families.

In the long run this attempted inflationary solution is a slow motion poison for both bonds and stocks (although deadly for bonds), the first coerced into low yields, the second when price controls are later imposed to smooth the inflationary blow.

Portfolio: liquidity trumps fundamentals

Fundamentals have left the investment temple for a long sabbatical, leaving us investors to build a portfolio based on monetary and political hypothesis. So far the severity of this financial crisis remains underappreciated, its durability badly underestimated and its complexity un-comprehended as more and more economic and financial variables are at levels unique to this crisis. We are clearly in uncharted territory.

The monetary and financial experiment underway has all but eliminated fair value from traditional asset classes, from money markets constrained by zero rates to bonds yield restrained by financial repression, from equities overvaluation from traditional metrics (CAPE, Tobin-Q) to rental yields at or below inflation. Either we await patiently the end of ZIRP to rediscover fair value, and it’s going to be a long wait, or we follow the flow and try to front run the monetary machinists as they keep adding liquidity to an overleveraged system.

In the epic battle between the tectonic forces of debt deflation on one side and monetary and fiscal reflation on the other, we have to balance the portfolio in a way that both tail risks are contained and hedged. The traditional approach to asset allocation is challenged by a large range of probabilities that include extreme monetary, socio-economic and political outcomes on the tails and systemic over-valuation at the core.

The announcement of open-ended quantitative easing has significantly reduced the deflationary tail risks by increasing its inflationary equivalent. We will adjust to this policy by rebalancing the short S&P to much lower levels in coming months and by increasing REIT and gold mining companies in the portfolio. The fix income portfolio current duration will be shortened progressively by not reinvesting maturing bonds at the upper end of the ladder.

Bonds of good quality corporate with low gearing and solid balance sheet will be privileged with less than 5 year average duration as ZIRP creates a solid support under bond markets until 2015. While yields are low and declining, there is some scope for further capital appreciation in this compartment before this asset class becomes one of the greatest destroyers of wealth later in the decade.

Our quest to buy equities at reasonable levels has been frustrated by the market continuing expansion of the multiplier driven by central banks liquidity injections. Pricing power, earning visibility and balance sheet solidity should guide our equity selection in the higher dividend compartment to generate yield pending a recession/market consolidation.

The supply of publicly traded safe havens and AAA is dwindling fast; this leaves us with few options but to look for alternative core assets that are scarce and in demand like gold and silver, selective properties in prime locations but at reasonable yields, fine art and sustainable income sources. Most of all, we should be looking for real assets underpinnings.

REITs offer a balancing act between the necessary inflation protection, pricing power and income generation within reasonable gearing levels.

Precious metal mining companies are now posting P/B and P/E ratios that offer significant capital protection in a reflationary world.

We maintain cash in the last few remaining solid currencies, both from a monetary and fiscal standpoint: SGD, CAD, NOK, and THB. The Euro remains a structural short while we maintain a neutral position on the USD.

 

All the best
Franco

Bangkok, September 30th, 2012

 

 

Noticeable in the past quarter:

  • Major US indexes enjoy one of their best quarters, also conspicuous for the absence of volume and declining earnings
  • In the US more people join every month the disable ranks and the food subsidy program that the employment rolls
  • The German Constitutional Court endorses the ESM as expected, but restricts the amount. The ESM will not be leveraged.
  • Mario Draghi promises that the ECB will do whatever it takes to save the Euro, starting with loosen collateral requirements and unlimited purchase of bonds of sovereigns that require a ESM bail-out
  • FED battles the law of diminishing returns with an open-ended quantitative easing and by extending ZIRP into 2015
  • The new Spanish bank stress test gimmick is published, based on 2011 numbers: banks will need at most EUR 59bn new capital provided that they are able to raise 73bn from deleveraging assets not yet collateralized at the ECB, 61bn from future net profits, that house price stabilize and that deposits increase 2% from their current levels! Good luck with all that!
  • Moody’s estimates that Spanish bank, with already 10% of NPL on their books, will need extra capital between EUR 75 and 105bn.
  • Russia joins the WTO

Upcoming in the next quarter:

  • Americans to chose between a leaderless incumbent administration and an out-of-touch challenger in one of the worst ideological polarized Presidential election
  • Pain in Spain: Catalonians to vote on secession
  • Greece or Grexit: next bail-out tranche from the troika in October
  • US faces a fiscal cliff if the usual can-down-the-road is not kicked in December
  • China to undergo once in a decade leadership change
  • China and Japan locked into a geo-political kabuki play